A Partial Primer to China’s Biggest Shadow: Entrusted Loans

Loans between companies is the fastest-growing category of shadow banking in China, but with next to no data on where such loans are going, their effect on the economy is a black box.

But two academic papers published over the last year on such lending – known as entrusted loans – offer a rare glimpse into how these loans work. The findings? Entrusted loans may have become the single most important factor keeping China’s property developers afloat. More broadly, the risk of such lending might be less than the huge issuance figures suggest.

Nonbank or shadow lending has ballooned in recent years as regulators have repeatedly tried to cut off certain sectors of the economy from formal financing channels. But each time Beijing has tried to crimp one source of credit, another avenue appears to take up the slack.

Now it’s entrusted loans. Such forms of lending increased by a net 2.55 trillion yuan ($407.38 billion) last year, equivalent to 29% of all new yuan bank loans issued during the year. That’s up from 1.28 trillion yuan in 2012, when they stood at only 16% of bank loans.

Based on a survey of nine major banks in Shanghai for a paper submitted in May, Wang Jiahui, an assistant researcher at the Shanghai headquarters of the People’s Bank of China, found that in 2011 about 21% of all entrusted loans went to the property sector, up from 19% in 2010.

And in a paper late last year based on a review of entrusted loans that were issued by listed Chinese companies between 2004 and 2013, two academics at the Huazhong University of Science and Technology found that about 20% of such loans over the nearly 10-year period went to the property sector.

If those results are representative of all entrusted loans nationwide – and that’s a big if – then companies lent about 766 billion yuan to developers in 2013, marginally more than banks and more than twice the amount of funding trust companies provided. Some of these loans carry high interest rates and there are signs some borrowers are having trouble repaying them.

Zhejiang Longsheng Group, a chemicals maker in eastern Zhejiang province, said in its 2013 earnings report that it extended the maturity on 199.5 million yuan worth of entrusted loans to three developers last year. The interest rates on those loans ranged from 23% to 25%. Longsheng officials declined to comment.

Once a money spinner, entrusted loans are no longer generating major returns for Longsheng like they used to. The company earned 21.9 million yuan from loans it made to other companies last year, down 77% from 2012.

For the most part, however, entrusted loans are lower risk than other types of shadow banking. They are mainly used by conglomerates to move cash between units, offering companies a way to manage resources in the course of everyday business. Such transactions usually carry very low interest rates. According to the two reports, about 80% of all entrusted loans are between these kinds of “related parties.”

During good times, there are plenty of reasons to shuffle cash from one unit to another. For a group of companies tied together by common shareholders, it makes sense to use collective cash holdings to cover funding needs, rather than to pay more to borrow money from a bank.

However, when these sorts of transactions pick up during bad times, it could be that some units, such as steelmakers or property developers, can’t pay their bills—from interest on a bank loan to payments owed to suppliers or wages due to employees. So money is diverted – as entrusted loans – from units that have cash to those that don’t. To put it another way, the healthy parts of a corporation end up subsidizing those that are struggling.

Without official data – or at least more extensive data – it’s impossible to have a precise picture of where money from entrusted loans is going, or even assess how big a risk such lending poses to the economy. But based on a partial snapshot, they may have become a lifeblood for struggling industries—the property sector in particular.